Have investors gone mad?

AnthonyMirhaydari

Anthony Mirhaydari is a columnist and blogger for MSN Money who writes on stocks and the economy. He is also the founder and publisher of
the Edge, an investment advisory newsletter. Previously, Mr. Mirhaydari was a senior research analyst with Markman Capital Insight, an advisory and money management firm, and a business consulting analyst with Moss Adams, focusing on the financial-services industry. He studied finance at the University of Washington's Foster School of Business, graduating magna cum laude.

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How quickly investors have recovered their resolve. Big worries like Ukraine, Chinese debt problems, emerging-market currency volatility, and a sooner-than-expected start to the Federal Reserve's policy tightening have all melted away like the last of winter's snow in the springtime sun.

But let's be honest: The catalyst for the move to new record highs for the S&P 500 has nothing to do with earnings growth rates, economic growth, investor positioning, or attractive valuations. It has nothing to do with fair and unrigged markets, as the growing scandal over high-frequency trading proves.

This is about momentum for momentum's sake. Buying because the market is rising. Buying because somewhere, somehow, there is the promise of more stimulus (currently, out of China and Europe). Buying because the yen-carry trade -- which supported the market into its final peak in 2007 — seems like it'll continue forever.

Because on the fundamental metrics, the support just isn't there. Most are demonstrating classic late-market-cycle behavior.

Profitability is under pressure from a tightened labor market and subdued revenue growth. Global growth is stalling. Investors are out of cash and into risky assets on a scale that exceeds, on some measures, the 2000 and 2007 market tops. As for earnings, an analysis by James Montier at GMO shows that on a number of valuation metrics, the S&P 500 is "significantly overvalued" and suggests that at these levels, investors should expect to merely breakeven over the next seven years.

That's right. A 0% return.

The technicals aren't all that great either. During Wednesday's push to new records, breadth was mediocre, with just 455 net advancing issues on the NYSE, down 66.2% from Tuesday. And the S&P 500 continues to tag new highs on less-than-stellar participation: Less than 8% of its constituent stocks also closed at a new high, and more than 300 are more than 3% away from a new high.

When the S&P 500 hit a record back in May 2013, according to Jason Geopfert at SentimenTrader, it did so with nearly 40% of its components participating. Over the last 10 years, such a narrow rise to new highs happened 10 other times. Only two managed to hold onto additional gains over the days, weeks, and months that followed (September 2006 and January 2013).

It's all about the currency-carry trades right now, or shorting a weak currency to raise capital to speculate in strong currencies. The trade has been focused on shorting the Japanese yen, which has been actively devalued, out of desperation to lift their economy out of a multi-decade stagnation, by Tokyo.

This was exactly the situation in mid-2007 as a big gain in the euro vs. the Japanese yen compressed euro-zone bond spreads, lulled retail investors into a false sense of security, and brushed aside warnings that maybe all those mortgage-backed securities weren't as "risk free" as the guys on Wall Street were saying.

Then the bubble popped, the yen carry's one-way trend gave way to chop and volatility, and the stock market ramped to one final high in October of 2007 on narrow volume. Just 70% of S&P 500 stocks were in uptrend when that high was put in; down from the 80% seen at the high at the start of the year.

Right now, the market is hitting records with 74% of S&P 500 stocks in uptrends; down from 84% at the start of the year. And again, we're seeing the market follow the yen-carry trade tick-for-tick during trading — exposing the U.S. stock market and all the people investing in it to the extreme volatility of the currency markets.

While stocks seem so invincible right now, their Achilles' heel is the yen. If it strengthens, for whatever reason, the market will collapse under the weight of overleveraged pair trades. And the stakes couldn't be higher, with the yen-devaluation strategy losing steam for Japan, which is suffering from higher inflation (due to a weak currency and the effect on import prices), economic stagnation (as consumers cut back), and the looming drag of the first sales-tax hike since 1997 (from 5% to 8%).

It's crazy that amid growing evidence that the market is rigged by high-speed computer traders and that stocks care more about the value of the yen than earnings growth, regular investors are buying into the mania heart and soul.

Caution is warranted. I'm recommending folks raise cash as the very least, or consider defensive positions in areas like Treasury bonds. For the more aggressive, consider positions like the ProShares UltraShort China FXP, +1.36%
which I've added to my Edge Letter Sample Portfolio.

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